May 10 (Bloomberg) -- Puerto Rico has been battling budget
deficits for 12 years, has a public pension that’s 9 percent
funded and a debt load almost as big as its economic output.

That hasn’t dimmed demand for its bonds from municipal
mutual funds catering to investors living in Silver Spring,
Maryland, and Virginia Beach, instead of San Juan and Vieques.

OppenheimerFunds Inc.’s Maryland, Virginia and North
Carolina tax-exempt funds hold more than 30 percent of their
assets in debt issued by Puerto Rico and its agencies, data
compiled by Bloomberg show. The bet paid off in the last year as
investors hungry for yield and an exemption from local, state
and federal taxes bid up securities from the island, which has a
lower credit rating than any U.S. state.

“It’s not the first thing that most people would expect
when they buy a fund with their own state’s name on it,” Eric
Jacobson, director of fixed income at research firm Morningstar
Inc. in Chicago, said in an interview. “Investors are courting
the income that these funds are throwing off. The question is,
do they really understand where it’s coming from.”

With local-government yields at the lowest since the 1960s,
investors are looking past Puerto Rico’s chronic budget deficits
and the threat of a downgrade from Moody’s Investors Service.

Puerto Rico bonds earned 15.6 percent in the past year,
beating all U.S. states and territories and the 11.3 percent
return for the $3.7 trillion muni market, Barclays data show.

Moody’s in August lowered Puerto Rico to Baa1, three levels
above speculative grade, and gave it a negative outlook because
of its deteriorating pension fund and history of borrowing to
bridge budget deficits. Standard & Poor’s rates Puerto Rico BBB,
two steps above junk.

A cut in the commonwealth’s rating could force selling,
Boston-based Breckinridge Capital Advisors said in a March
commentary.

“Puerto Rico has systemic risk because it’s so widely and
ubiquitously held because of the favorable tax treatment,” said
Matt Fabian, a managing director at Concord, Massachusetts-based
Municipal Market Advisors.

Much of Puerto Rico debt held in the Virginia fund was
issued to finance utilities, highways and schools, and backed by
dedicated revenue such as sales taxes and tolls.

The fund’s percentage of Puerto Rico holdings ranged from
23 percent to about 40 percent from 2008 to 2011, according to
annual fund statements. As of March 29 it was about 35 percent,
according to Bloomberg data.

Tanya Valle, a spokeswoman for New York-based
OppenheimerFunds, declined to comment.

The holdings can spur volatility. The Virginia fund
returned 47.1 percent in 2009 and lost 36.7 percent in 2008.

“Some of the mutual funds are probably over-weighted on
territories,” said Matt Dalton, chief executive officer of
Belle Haven Investments Inc. in White Plains, New York.

March Sale

OppenheimerFunds’ state-specific funds have no restrictions
on the percentage of investment-grade debt issued by Puerto Rico
or other U.S. territories. The funds can invest as much as 25
percent of assets in below-investment-grade securities.

In March, Puerto Rico issued $2.3 billion of general-obligation bonds with 20-year debt yielding 5 percent. That’s
equal to a 7.7 percent taxable yield for investors in the top
bracket. Puerto Rico got $1.3 billion in excess orders for the
sale and boosted it by about 50 percent.

“Our concern specifically is market access,” said Robert
DiMella, co-head of MacKay Municipal Managers, in an April 18
interview in New York. “They need to issue more debt.”

DiMella said he doesn’t expect Puerto Rico to default on
its general-obligation bonds. His colleague John Loffredo said
almost $4 billion of bonds backed by appropriations from the
Legislature will have to be restructured.

Debt Load

The island’s debt-to-gross domestic product ratio grew to
90 percent in 2010 from 57 percent 2001 as officials borrowed to
close deficits that have persisted for 12 years, according to
Breckinridge. Illinois’s ratio of debt to annual output is 4
percent, according to Breckinridge. Illinois’s A2 Moody’s
rating, lowest among states, is two steps above Puerto Rico’s.

Assets in its Employees Retirement System were 8.5 percent
of projected liabilities at year-end, according to the
commonwealth. By comparison, Illinois’s ratio was 45.4 percent
as of 2010, the weakest among all states, data compiled by
Bloomberg show.

Governor Luis Fortuno, who is up for re-election in
November, last year signed into law annual increases to yearly
pension payments through 2021.

“We continue to evaluate alternatives to further extend
system assets,” Juan Carlos Batlle, president of the Government
Development Bank, said in an e-mail.

“The realistic goal is to at least balance outflows and
inflows to meet retirement obligations, protecting the solvency
of the plans until the system auto-corrects after 2040,” he
said.

Payroll Cuts

Fortuno has cut 17 percent of Puerto Rico’s payroll since
taking office in 2009. He also implemented a property tax and an
excise tax on manufacturers not based in the commonwealth.

Its economy may grow 0.9 percent in the year ending June
30, the first expansion since 2006, according to the Puerto Rico
Planning Board.

In Wisconsin, only about 10 percent of debt issued annually
is exempt from state taxes, said Lyle Fitterer, a managing
director at Wells Capital Management. He oversees a tax-free
Wisconsin fund that had about 32 percent of its assets in Puerto
Rico debt as of Dec. 31.

About 3 percent of its holdings were uninsured Puerto Rico
general obligations that mature in the next few years. About 7
percent consist of longer-maturity Puerto Rico securities backed
by dedicated revenue such as sales taxes or tolls. The rest of
the commonwealth debt is backed by U.S. Treasuries, securities
with credit support from banks that can be redeemed weekly or
monthly and federal aid.

“You’ve got to look under the hood,” Fitterer said.
“Where we do own, it’s down short. It kind of reflects our view
on Puerto Rico that we don’t necessarily think that it’s a
default situation any time soon, but we’re worried about a
potential downgrade and therefore negative price performance.”

Following are pending deals:

METROPOLITAN ATLANTA RAPID TRANSIT AUTHORITY plans to sell
about $327 million in refunding bonds as soon as next week,
according to the offering document. The bonds will be backed by
tax revenue. Moody’s rates the bonds Aa3, fourth-highest. The
debt will be priced competitively. (Added May 10)

CALIFORNIA HEALTH FACILITIES FINANCING AUTHORITY plans to
issue $415 million of tax-exempt revenue bonds as soon as
tomorrow. Proceeds will help renovate Stanford Hospital &
Clinics facilities and refinance debt sold in 2003, according to
sale documents. Morgan Stanley will lead the marketing. Moody’s
rates the bonds Aa3. (Updated May 10)